Currency I: What does Wales need from a currency?

It’s probably the second most important question about independence after the budget: “What currency would Wales use?”

Just to underline how important it is, not being able to adequately explain the options could’ve played a big part in the failure of the Yes campaign during Scotland’s 2014 independence referendum and it could well be a thorn in their side in any IndyRef2.

Get it right, none of you will notice and you might even be/feel better off. Get it wrong and you’re looking at a Zimbabwean/Venezuelan-style economic catastrophe and people like me get put up against a wall and shot.

This is the first time anyone’s attempted to answer this in a Welsh context and it’s – without a shadow of a doubt – been the most difficult series I’ve done to date; harder than foreign affairs, defence….all of them. I’ve had to undertake a self-taught crash course in macroeconomics and monetary theory before attempting it and all I have to back me up is a maths GCSE and an A-Level in geography.

Don’t thank me all at once.

What is currency/money?

There are three key functions of a currency:

A standardised unit of value – Currency can be stored, banked, saved and spent with the individual units worth exactly the same for absolutely everyone from the top to the bottom of a society. Any commercial agreement from a car boot sale right through to international trade deals needs a standardised unit to measure the value of the goods or services provided. Currencies specific to a nation-state and/or can only be used in that nation state are called “legal tender”.

A medium of exchange – This is one of the reasons modern civilisation exists because being able to use currency to purchase or sell goods or services instead of having to barter or use commodities (like precious metals) speeds up trade. Imagine if you had to barter every single time you went to a shop; if you don’t have what the seller wants, you’re out of luck. Currency is faster, safer and universal. One £10 note is interchangeable with a currency of the same value even if made up of different denominations – like two £5 notes or 10 £1 coins (known as “fungibility”).

A standardised form of deferred payment – You can use currency to lend, borrow and pay off debts with the lender having confidence that what’s paid back will be of the same value as what was lent (plus interest where applicable).

Commodity & Fiat Currencies Explained

There are two broad types of currency – commodity currencies and fiat currencies.

Commodity currencies are based on the value of a material good whilst maintaining the functions of a currency (as outlined above), but can also be used for something else. For example, gold has its own intrinsic value and can be used as currency, but it can also be used to make jewellery, used as an industrial coating, in electronics etc.

Fiat currencies are worthless. Before you panic, what I mean is they represent a value but don’t have any other purpose other than acting as a currency. A £10 pound note is worth £10 because the government and central bank it says it is, but whatever’s used to make the note is likely to be worth a fraction of a penny. All modern currencies are fiat currencies and exist mainly as numbers on a computer screen.

There are advantages and disadvantages to both.

Commodity-based currencies fluctuate in value (on commodity markets), but they’re usually a safer bet as an investment. When used to make coins, those coins retain their value even if the government collapses or changes. However, they may vary in quality so one coin, diamond or bar of gold may not be as worth as much as another and it’s hard to divide into sub-units (like pounds and pence) – this would be incredibly confusing if used in everyday life.

Fiat currencies are much better as a medium of exchange because they have government backing (for stability) and they can be broken into smaller units. However, they’re more prone to inflation and deflation and can be devalued – meaning the purchasing power of a fiat currency can radically change in a short space of time, particularly if a government “prints more money”.

As said, all modern currencies are fiat currencies and it’s inevitable Wales will adopt a fiat currency – though I come back to possible alternatives in Part VII.

Money Problems

If I’m still going, I’ll probably go into these in more detail in separate posts, but for now, it’s worth briefly looking at some of the negative problems associated with currency-based economics.

Money laundering – Putting money obtained through illegal activities through a legitimate business in order for the money to look “clean”. There are numerous ways to do this – too many to mention here – but some of the most common methods are using offshore bank accounts, setting up shell companies and trusts, gambling and property.

Counterfeiting – Finding a counterfeit bank note is rare, but counterfeit coins are a problem, even in the UK. According to the Royal Mint in 2015, around 2.6% of all £1 coins in circulation were fake and subsequently, the Bank of England has now introduced the more fraud-proof dodecahedral £1 coin to replace the old circular one.

Inflation & Hyperinflation – Where prices rise gradually over a period of time, weakening the purchasing power of a currency. There’s no single cause, but it’s generally the result of an increase in the amount of currency in circulation, whether that’s due to central banks producing/printing more money or prices rising due to demand outstripping supply (meaning more currency is needed to buy things). Hyperinflation is almost certainly due to governments printing more money to cover debts, which causes runaway price increases and massive devaluation of the currency to the point of worthlessness, often resulting in foreign currencies being used alongside/instead of domestic ones (see 1920s Germany, Venezuela, Zimbabwe etc.).

Deflation – The opposite of inflation, where prices fall. You might think this is a good thing because it increases the value of a currency, meaning you can buy more things with less. But what it also does is increase the value of debt, or results in big interest rate increases. That has a huge impact on credit-based free market economies because of lower production caused by lower prices (higher interest rates encourage people to save, not to buy); wages fall and eventually unemployment rises. Most major economic depressions have had a deflationary cycle and it’s arguably worse than inflation.

Currency strength – This can be good or bad depending on the state of a nation’s economy and what they do best at.

A “strong currency” (where the currency is valued highly on foreign exchange markets) generally means a nation has a lot of purchasing power and can buy more foreign currency than they would otherwise be able to, making imports cheaper because they are priced in less valuable currencies.

A “weak currency” (where a currency falls in value relative to others) reduces purchasing power but at the same time makes exports cheaper because foreign countries can “buy more with less”.

It’s generally better for countries that are reliant on services and consumerism, particularly financial services, to have a strong currency. Greater purchasing power is better if you’re simply shifting money around or selling imported goods because you have a stronger hand in the marketplace – a bit like a “high roller” walking into a casino.

Meanwhile, countries focusing more on physical exports and manufacturing (like Wales) need a weak currency to make their products more attractive and affordable to other countries.

That’s a simplification of the reality, but it’s why the post-Brexit referendum decline in the value of the pound could see supermarket prices rise and imports fall, but at the same time boost UK manufacturing – recent reports suggesting Welsh manufacturing alone has been boosted by 3.1%.

What should nations demand from a currency?

In 2013, the Fiscal Working Group of Scotland published a report into the possible macroeconomic framework of an independent Scotland – including currency options (pdf). There’s no reason why this wouldn’t apply to Wales too, though the underlying economic conditions are different.

Some of this is taken from that report, some of it is original. The (at least) eight factors we would have to consider can be broadly drawn into two categories:

Autonomy – The ability to make policy to deal with changing economic conditions, which could include a Central Bank, the ability to devalue the currency, change monetary supply and change interest rates.

Convertibility – The ability to convert into another currency on foreign currency exchange.

Credibility – Appropriate regulation of the financial service sector to give businesses, financial markets, investors and individual consumers confidence in the currency and monetary policy.

Stability – The ability to withstand macroeconomic pressures like unemployment, public debt and economic recessions.

Category Two: Socio-economic – the impact on wider society and how the economy functions on the ground (“the pound in your pocket”).

Foreign trade – How choice of currency affects who and how we can trade with different nations, whether in a formal currency union or with an independent/floating currency.

Identity – Currencies are an important national symbol, so how the currency represents Wales is a consideration.

Mobility – How easily will people and businesses be able to move between countries for work, for leisure or to do business?